Abstract
Many empirical studies have found little relation between sample mean returns of securities and estimated betas. Some of the studies have uncovered variables other than beta (e.g. firm size, ratio of book-to-market value, price/earnings ratio) that have power in explaining the sample cross-sectional variation in mean returns. The present paper shows that a possible explanation is that market ...
Abstract
Many empirical studies have found little relation between sample mean returns of securities and estimated betas. Some of the studies have uncovered variables other than beta (e.g. firm size, ratio of book-to-market value, price/earnings ratio) that have power in explaining the sample cross-sectional variation in mean returns. The present paper shows that a possible explanation is that market portfolio proxies are mean-variance inefficient. It is shown that inefficiency of the market proxy renders estimates of the regression coefficients of the cross-sectional relationship biased. In order to illustrate the problems an artificial capital market is generated. In this financial market the CAPM is valid. It turns out that the bias of the parameter estimates may be considerable, and inference about the validity of the CAPM or about the significance of "anomalies" based on these estimates may be extremely misleading.
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